2. ESG principle in the financial sector
2.2 Climate-related risks
investments are no longer sustainable and supported by the financial sector. This is true and relevant because the EBA Guidelines on Loan Origination and Monitoring are oriented to consider ESG factors as taken into account in banks’ credit risk appe- tite, policies and procedures.
The analysis of ESG risks requires a real ESG disclosure; this means that banks must map all business units and divisions on the basis of ESG risks’ framework and above all on the basis of the inside-out and outside-in perspective.
This mapping is finalized to manage the risk of conflicting or inconsistent infor- mation being disclosed; to ensure consistency and/or alignment of the disclosure;
and to identify the overlaps in the reporting pillars where common reporting metrics can be considered. This kind of risk disclosure is important as it is the expression of internal analysis and mapping of ESG risks, which must be constantly monitored in the next future. This mapping can be considered as an absolute improvement of Basel Third Pillar.
activities. The Green Asset Ratio is based on the EU taxonomy. It is a measure of the financial support that banks are willing to give to sustainable activities. Through this ratio, it is possible to put in evidence the assets that can be considered environmen- tally sustainable as they are referred to grant finance to activities of climate change mitigation on climate change adaptation. It is important in setting strategies, and even a bank with a low Green Asset Ratio can identify how it wants to change its financing activities over time to meet the Paris agreement objectives and measures. It gives information about a strategy that must be monitored. It is expected by EBA to receive from counterparties subject to NFRD disclosure obligations reliable data for the Green Asset Ratio from December 2022, developing a framework that identifies the required disclosure standards and their materiality triggers. The most commonly referenced framework in the case of climate disclosures is the TCFD framework, which is recognized by regulators in the EU and is considered as guidance on climate- related disclosures.
Banks and financial institutions are exposed to climate-related risks through both their own operational impacts and the activities of their borrowers, customers, or coun- terparties. According to the outside-in and inside-out approaches, banks that provide loans or trade the securities of companies with direct exposure to climate-related risks suffer and accumulate climate-related risks via their credit and equity operations. In addition, as the markets for lower-carbon and energy-efficient alternatives grow, firms may assume material exposures in their lending and investment businesses.
The ECB Guide [5] represents a shared document that shows how relevant are a disclosed analysis of such risks to grant that banks are managed in a sound and safe way. The relevance of climate-related risks is really great and the ECB has declared that banks conducted a self-assessment in light of the supervisory expectations outlined in the guide and to draw up action plans on that basis. The self-assessment plans will be considered by ECB as the first step toward more accurate monitoring of climate risk among all typical financial risks. This importance is also evident in the declaration of the climate-related risks stress test that will be run by ECB during this year.
2.2.1 Physical risks
As it has been described above, physical risks are specifically referred to as natural catastrophes and the economic losses caused by them; and this situation has increased in the last decades. The number of some types of extreme weather events has globally increased. Such events have become more likely or more severe due to the effects of climate change, and it is known that further warming will intensify them and conse- quently the negative effects at the basis of the increase of climate risk.
Physical risks include losses stemming from changes in physical capital because natural disasters destroy infrastructure and divert resources toward reconstruc- tion and replacement. These risks affect also human capital, through deterioration in health and living conditions. The hard conditions due to the physical risks may have consequences on future expectations with a reduction of investment, given the prevailing uncertainty about future demand and growth prospects.
If there is no action to reduce the effects of climate change, physical risks will continue to increase in the future. The frequency and severity of extreme weather events might increase non-linearly and become increasingly correlated with each other over time. The consequences of physical risks can affect mainly market and credit risks.
The climate risk consequences may influence the value of financial assets causing losses for banks, investors, and financial institutions. The losses are the expression
of market risk, but they are not directly caused by negative movement of financial variables (i.e., interest rates or assets prices), instead, their origin is connected with the losses due to the material destruction due to physical risk. As concerns credit risk it is almost easier to be understood as it is the consequence of the impossibility to repay and/or to reimburse loans, because of the physical destruction of assets, things, or the death of human beings. It is evident that banks are in presence of a large and composite number of risks and aspects of the same risk [4].
The impact of physical risk is not easy to be estimated with the effect on a bank’s assets. Estimates are based on a number of assumptions and subject to numerous sources of uncertainty concerning the global emissions with the potential increases in global temperatures and the severity of extreme weather events. So, the macroeco- nomic scenario and the variation in financial assets value are highly uncertain. Finally, there are the uncertainties associated with the future path of climate change and its impact on asset prices. Heating temperatures are increasing climate risk and physi- cal risk in particular. They seem to be unavoidable, and this will cause an increase of negative effects on the financial system and assets prices [6, 7]. As physical risks are different in the sector and geographical areas, market and credit risks may be affected by these differences. This condition reinforces the situation in which other differences and in particular significant losses derive also from the disruption at the national level, and concentrated in certain countries with and exposure to operational risks that could disrupt firms’ operations, and affect other firms (financial and non-financial) pro- vided by banks’ financial services amplifying risks for financial stability.
2.2.2 Transition risks
It is known the necessity of bringing the temperature to be below 2° C above pre-industrial level. Transition risks stem from the possible process of adjustment to a low carbon economy, and its possible effects are expected on the value of finan- cial assets and liabilities. Such a transition to a low carbon economy would imply significant structural changes to the economy, including a major reallocation of investment. This could have a significant impact on firms involved in the produc- tion of fossil fuels, as well as other sectors whose business models rely on using such fossil fuels or that are energy intensive. The effect changes in asset prices with consequences on banks’ portfolios. These prospective effects might have also the consequence of reallocating financial resources from highly risky sectors or busi- nesses tied, for example, in fossil fuels to new and less pollutant activities, by doing so supporting a real transition to a green economy. We can affirm that there will be a transformation of banks’ strategies and the support of market segments devoted to new and more sustainable sectors. We can say that the transition risks represent the lever to accelerate banks’ contribution to a renewal of economy and financial flows besides the real beginning of sustainable finance. On the contrary, a disorderly transition to a low-carbon economy, unanticipated by market participants, could have a destabilizing effect on the financial system. The most relevant effect will be an increase in credit risk due to the instability of such companies operating in brown sectors and receiving loans from banks. A transition to a low-carbon economy might reduce some borrowers’ capacity to generate sufficient income to service and repay their debts [8]. From this situation, banks are forced to face a higher credit risk, which is the result of a double scenario. The former is connected to the well-known difficulties in payments, and the latter is the increasing risks connected with the reduction of collateral value [7]. Transition scenarios are not able to catch all policy,
technology and/or consumer preferences they change very rapidly. Moreover firms’
vulnerability to transition risks isn’t easy to be evaluated; in fact it is not only due to the firms’ operations, but also to their suppliers and customers.